The Investing in Inclusive Finance program at the Center for Financial Inclusion at Accion explores the practices of investors in inclusive finance. Across areas including risk, governance, stakeholder alignment, and fund management, this blog series highlights what’s being done to help the industry better utilize private capital to develop financial institutions that incorporate social aims.

It may not be explicitly articulated and may be just “what we do” but all MFIs have a risk strategy and risk appetite. Board members have a responsibility to become active shapers of their organizations’ risk strategies and appetites, so that they can guide their institutions into waters of appropriate depth.

Each board member brings different perspectives to the table, but collectively, the board needs to have a view on the key macro and micro entity and performance risks and their possible impact on the MFI. At a high level these risks can be broken down into strategic/business model risks (clients, products, and delivery channels), operational risks (i.e., how the MFI functions), financial risks (funding, liquidity, FX risk), and compliance risks (adherence to regulations, client code of conduct). However, setting and monitoring risk strategy and appetite is not a checklist exercise. There are some on-going broader risk guidance principles that boards might utilize as part of being explicit about risk strategy and appetite.

Set Risk Culture/Tone at the Top:

Risk management is about managing MFI performance against expected performance. Boards represent shareholders and stakeholders who have an established view on the MFI’s expected performance and business and risk boundaries. This view is evidenced in plans, guidelines, minutes, and the focus of on-going board agendas. New investors, who signify change, can alter this consensus around expected future risk, profile, and performance. In any event the view of risk is dynamic. Market vagaries and operational performance will inevitably require on-going risk profile adjustments to strategic, operational, financial, and compliance risks, and lending models. This degree of risk tolerance, “how we operate,” will trickle-down throughout the entire institution from the board to the management to individual, daily staff decisions.

Create Risk Boundaries:

For overall and major business decisions, boards should discuss the potential range of expected outcomes, including the ideal, base, and downside cases with a stress testing approach to risk assumptions. Discussion can then focus on the interaction of these risks, identifying “Achilles heel” issues. The range of tabled results or “risk curve” helps to explicitly identify business/risk trade-offs to establish an agreed position and shared understanding of likely downside scenarios and the related financial P & L, balance sheet, and other risk implications. It is the board which sets the boundaries around the business (clients, products, geography, operational platform, etc. – and resultant risk profile) based on these risk trade-offs and provides direction to management about these risk boundaries and business risk tolerance.

Know What You Don’t Know:

Part of every board meeting should be dedicated to “looking out the windscreen not just at the dials” to identify material strategic risks that are inherent with the MFI’s business model. Once determined, this leads to a shared perspective on the key metrics that need to be monitored. There should be periodic strategic updates and discussion on how changes will impact the business of the MFI, with boards asking “what about this?” to raise concerns over politics, over-indebtedness, etc. A well-composed board, drawing on relevant knowledge or experience, should facilitate a collective “reading the tea leaves” to provide an understanding of the larger context within which the MFI is operating. As part of regular business reviews, the board should ask: “What don’t we know?” and with that, “Who should we be asking?” How do we “look out the windscreen” to spot unknown risks, and implement appropriate mitigating actions to minimize surprises?

Risk is Part of the Business:

All financial institutions are inherently in the risk business. Risk is an integral part of the business and should be an aspect of every business discussion and decision. With lending, the upside is interest net margin, while the downside is loss of principal and interest. So, with this, negative gearing risk is at the core of any financial institution’s business model. Risk appetite is determined by looking at projected risk exposure against risk bearing capacity and expected returns.

Some established institutions have set up a formal board risk committee reporting to the board of directors on the institution’s risk profile and risk management framework, including the significant policies and practices employed to manage risks in the business, as well as the overall adequacy of the risk management function.

The changing titles of the Microfinance Banana Skins surveys highlight how the macro risk landscape has changed from a focus on internal management and capacity building risks, to external, macroeconomic, reputation, competitive environment, and on-going relevancy to clients. This is illustrative of the ever-changing context which requires an evolving and collectively understood business model and risk position. This requires boards to take a proactive, holistic, informed, and disciplined approach to setting explicit business and risk boundaries, and monitoring and managing against them. What are our key context and business concerns? What are the risk profile and performance implications? What are the appropriate mitigating actions? Where might we expect surprises? Have we set the tone at the top and appropriate business and risk boundaries?

*Many established MFIs are now regulated financial institutions, with developed and formalized risk and governance practices, so the observations contained within this post are focused more on MFIs that are growing and transforming.

This post comes from Investing in Inclusive Finance’s forthcoming risk expert exchange. In this expert exchange, 10 industry risk experts each address one tough risk question as Philip Brown has done here. Topics such as over-indebtedness, fraud, “newer” risks, and lack of information will be examined in this risk expert exchange, offering insight on some of the most difficult risk issues that board members face. This publication will be available electronically on the CFI website in the coming weeks.

Philip Brown is Managing Director Risk for Citi Microfinance’s global business. He is responsible for developing the policies, programmes and risk tools to enable Citi’s businesses to commercially engage with microfinance, financial and other institutions, networks and investors, to expand access to financial services in underserved communities. Mr. Brown is a member of the Governing Council of the Centre for the Study of Financial Innovation (UK), the Advisory Council of the Centre for Financial Inclusion (USA) and the Advisory Board of the Council of Microfinance Equity Funds.

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Credit Suisse is a founding sponsor of the Center for Financial Inclusion. The Credit Suisse Group Foundation looks to its philanthropic partners to foster research, innovation and constructive dialogue in order to spread best practices and develop new solutions for financial inclusion.

Note

The views and opinions expressed on this blog, except where otherwise noted, are those of the authors and guest bloggers and do not necessarily reflect the views of the Center for Financial Inclusion or its affiliates.